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Debt and borrowing

Question: Is it better to pay down debt (ie. mortgage or car loan) during periods of inflation or deflation? I understand that it's a good idea to invest during deflation (because the interest rate is added to the deflation rate) and take on debt during inflation, but if an individual took on a mortgage in 2005, is it more financially advantageous to make extra mortgage payments during a period of deflation or inflation? Rebecca, St. Cloud, MN

Answer: First, let's look at the impact of inflation and deflation on borrowing. It only becomes significant at the extremes. When inflation is raging at double digit levels, such as in the late 1970s and early 1980s it does make sense to borrow since you're paying back the lender with depreciating (less valuable) dollars. When the fall in the overall price level is steep--like the Great Depression--the real cost of those debt payments is surging. You don't want debt during a severe deflation.

But during periods of low inflation (such as what we had for much of the past three decades) or mild deflation (which was the case for much of U.S. history before World War II) the message is the same: It's equally advantageous to make extra mortgage payments. You lower your debt burden and reduce the amount of interest you pay to own your home. The main reason not to accelerate payments has nothing to do with the direction of the overall price level. Instead, the concern is putting too much of your money into one asset--a home. Before making those additional payments my standard recommendation is to make sure you have set aside enough in emergency savings and a well diversified portfolio for retirement.

How about investing in a deflationary environment? Let's look at fixed income securities. Interest rates and bond prices are two ends of a seesaw. When bond yields are rising (usually from investors anticipating higher inflation), bond prices go down--and vice versa. Bond prices soared as bond yields came down sharply during the Great Depression. For instance, the prime corporate bond yield average went from 4.59% in September 1929 to 3.99% in May of 1931. By June of 1938 the average corporate bond yield fell to a new low of 2.94%. Government bonds returned about 6% during the 1930s, and short-term bills returned almost 3% over the same time period. Stocks did poorly for the decade.

Still, even fixed income investors are wary of deflation since unwary creditors absorbed huge losses during the 1930s as cash-strapped corporations and municipalities defaulted on their debts. That's why we are seeing a rush into default-free U.S. Treasuries.

Again, the kind of deflation matters. Prices fell at a frightening pace during the Great Depression. The investment record is different when deflation is mild. In many cases deflation and hefty investment returns in both stocks and bonds have co-existed. For instance, from 1802 to 1870 consumer price inflation averaged 0.1% a year. Stocks returned 7% during this period, according to Jeremy Siegel, finance professor at the Wharton School. Short-term government bills returned 5.1% and long-term governments bonds returned 4.8%. No matter how you slice the data the message remains the same, says James W. Paulson, chief investment officer at Norwest Investment Management. "Stock and bond returns run neck-and-neck when inflation is not a worry."